Market Microstructure Interface with Other Areas of Finance

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A popular measure of liquidity is the bid-ask spread which is the difference between the bid and the ask price quoted by a dealer who makes a market in a stock. The bid-ask spread may be viewed as the price required by the dealer for providing immediate execution of orders. Amihud and Mendelson (1986) examine the relationship between bid-ask spread and stock returns. If investors assess the value of a stock based on their returns net of trading costs, then they should demand a higher rate of return for high spread stocks so as to compensate them for higher trading costs. Thus, investment decisions should incorporate liquidity considerations in addition to risk. While an investor can reduce the risk by holding a diversified portfolio, the cost of illiquidity cannot be diversified away.

Besides required rate of return, liquidity also affects the holding period of a stock. The cost due to the bid-ask spread has to be borne by the investor only once over the holding period. A premium is paid when the stock is purchased and a price concession is made at sale. A longer holding period effectively reduces the amortized transaction cost per unit of time. The larger the holding period of an investor, the lower the extra return required compensating for the bid-ask spread. Thus, stocks with high bid-ask spread will be held by investors with longer holding periods. Conversely, short-term investors should hold low-spread securities.

Amihud and Mendelson (1986) show empirically that security returns reflect the percentage bid-ask spreads. Observed gross returns tend to increase with spread. By their estimates, the monthly excess return of a stock with a 1.5% spread is 0.45% greater than that of a stock with a 0.5% spread. These results have several implications for investment management. First, low liquidity investments are required to produce higher returns for the holders. Real estate and stocks of small firms typically have lower liquidity and therefore produce higher returns. Second, portfolio manager are advised to pay attention to investment horizons of their clients. While a client with a longer holding period is able to withstand the burden of some illiquid assets in her portfolio, other investors with shorter horizons should be directed to hold low-spread securities.

Amihud and Mendelson's framework points out to the benefits of liquidity increasing investments. As a direct consequence of liquidity improvements via lower spreads, the value of a stock should increase. This effectively decreases the cost of capital of the firm. One such move could be to switch the listing of the stock to a more liquid trading environment. Amihud et al. (1997) document large changes in stock prices of companies moving to a more liquid trading system on the Tel Aviv stock exchange.

The going public decision is one such project. The cost benefit analysis of the project is given by c E E

Ri Ri R

where C0 is the initial cost of the public offering, c is the recurring cost associated with public ownership, E is the perpetual cash flow generated by the firm, R is its initial cost of capital and R1 the cost of capital subsequent to the firm going public. This equation can be approximated as follows:

where (AR/R) is the relative reduction in the required rate of return.

Amihud and Mendelson (1988) discuss a number of implications of this model. First, a given change in liquidity has a greater effect on the cost of capital when liquidity is already high than when it is low. Thus, it may be more beneficial for forms which are already highly liquid to invest further in increasing the liquidity. Second, a given investment in a liquidity increasing project might provide a greater reduction in the cost of capital and a greater gain for low liquid firms. Third, the benefits of increased liquidity are proportional to the initial value of the firm. Thus, we should expect larger firms to benefit more and therefore to invest more in liquidity enhancing projects as compared to small firms. Finally, for some stocks decreasing liquidity rather than increasing it will be beneficial to the firm when the left hand side of (2) is greater than the right. This implies that the cost of increasing liquidity exceeds the potential benefits. Bharath and Dittmar (2007) provide empirical evidence by showing that low liquidity firms are more likely go private subsequent to their going public, ceteris paribus.

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